1

Chapter 2 – Integrative Problems

Analysis of Financial Statements

2

Problem 1

Donna Jamison was recently hired as a financial analyst by Computron Industries, a manufacturer of electronic components. Her first task was to conduct a financial analysis of the firm covering the past two years. To begin, she gathered the following financial statements and other data. Use the following statements to calculate the ratios for Computron Industries.

3

Problem 1

BALANCE SHEETS 2010 2009 ASSETS

CASH $ 52,000 $ 57,600ACCOUNTS RECEIVABLE 402,000 351,200INVENTORIES 836,000 715,200TOTAL CURRENT ASSETS $1,290,000 $1,124,000GROSS FIXED ASSETS 527,000 491,000LESS: ACCUMULATED DEPRECIATION ( 166,200) ( 146,200)NET FIXED ASSETS $ 360,800 $ 344,800TOTAL ASSETS $1,650,800 $1,468,800

4

Problem 1

BALANCE SHEETS 2010 2009 LIABILITIES AND EQUITY

ACCOUNTS PAYABLE $ 175,200 $ 145,600NOTES PAYABLE 225,000

200,000ACCRUALS 140,000 136,000TOTAL CURRENT LIABILITIES $ 540,200 $

481,600LONG‑TERM DEBT 424,612

323,432COMMON STOCK 460,000

460,000RETAINED EARNINGS 225,988 203,768TOTAL EQUITY $ 685,988 $ 663,768TOTAL LIABILITIES AND EQUITY $1,650,800

$1,468,800

5

Problem 1

INCOME STATEMENTS 2010 2009 SALES $3,850,000 $3,432,000COST OF GOODS SOLD ( 3,250,000)

( 2,864,000)OTHER EXPENSES ( 430,300) ( 340,000)DEPRECIATION ( 20,000) ( 18,900)TOTAL OPERATING COSTS ($3,700,300)

($3,222,900)EBIT $ 149,700 $ 209,100INTEREST EXPENSE ( 76,000)

( 62,500)EBT $ 73,700 $ 146,600TAXES (40%) ( 29,480) ( 58,640)NET INCOME $ 44,220 $ 87,960

 EPS $0.442 $0.880

6

Problem 1

STATEMENT OF CASH FLOWS (2010) OPERATING ACTIVITIES:

NET INCOME $ 44,220  OTHER ADDITIONS (SOURCES OF CASH):

DEPRECIATION 20,000 INCREASE IN ACCOUNTS PAYABLE 29,600 INCREASE IN ACCRUALS 4,000

SUBTRACTIONS FROM NET INCOME:INCREASE IN ACCOUNTS RECEIVABLE ( 50,800)INCREASE IN INVENTORY ( 120,800)NET CASH FLOW FROM OPERATIONS ($ 73,780)

  

7

Problem 1

 STATEMENT OF CASH FLOWS (2010)LONG-TERM INVESTING ACTIVITIES:

INVESTMENT IN FIXED ASSETS ( 36,000)

FINANCING ACTIVITIES:INCREASE IN NOTES PAYABLE $ 25,000 INCREASE IN LONG-TERM DEBT 101,180 PAYMENT OF CASH DIVIDENDS ( 22,000)NET CASH FLOW FROM FINANCING $104,180

 NET CHANGE IN CASH ACCOUNT ($ 5,600)

CASH AT BEGINNING OF YEAR 57,600 CASH AT END OF YEAR $52,000

8

Problem 1

OTHER DATA 2010 2009 DECEMBER 31 STOCK PRICE $ 6.00 $

8.50 NUMBER OF SHARES 100,000 100,000DIVIDENDS PER SHARE $ 0.22 $ 0.22LEASE PAYMENTS $40,000 $40,000

  

9

Problem 1 INDUSTRY AVERAGE DATA FOR 2010:

RATIO INDUSTRY AVERAGECURRENT 2.7xQUICK 1.0xINVENTORY TURNOVER 5.8xDAYS SALES OUTSTANDING (DSO) 32.0

DAYSFIXED ASSETS TURNOVER 10.7x TOTAL ASSETS TURNOVER 2.6xDEBT RATIO 50.0%TIE 2.5xFIXED CHARGE COVERAGE 2.1xPROFIT MARGIN 3.5%ROA 9.1%ROE 18.2%PRICE/EARNINGS 14.2xMARKET/BOOK 1.4x

 

10

A. What can you conclude about the company’s financial condition from its statement of cash flows?

1. The firm’s net operating cash flow is -$73,780, so its operations are draining cash despite the positive net income reported on the income statement

2. Because of its negative cash flow from operations, Computron had to borrow a total of $126,180 in long- and short-term debt to cover its operating cash outlays, to pay for fixed asset additions, and to pay dividends

3. Even after all this borrowing, Computron’s cash account still fell by $5,600 during 2010

11

B. What is the purpose of financial ratio analysis, and what are the five major categories of ratios?

Financial ratios are used to get an idea about how well the company is being operated, and where it needs improving1. Liquidity2. Asset management3. Debt management4. Profitability5. Market values

12

2010 2009 Industry Current ratio 2.4x 2.3x 2.7x Quick ratio 0.8x 0.8x 1.0x

Computron’s current and quick ratios have both held steady from 2009 to 2010, but they are slightly below the industry average

C. What are Computron's current and quick ratios?

13

C. What do Computron's current and quick ratios tell you about the company's liquidity position?

Computron’s current and quick ratios have both held steady from 2009 to 2010, but they are slightly below the industry average with a 2010 current ratio of 2.4With a 2010 current ratio of 2.4, Computron could liquidate assets at only 1/2.4 = 0.42 = 42% of book value and still pay off current creditors in fullComputron’s quick ratio of 0.8 indicates that even if receivables can be collected in full, the firm would still need to raise some cash from the sale of inventories to meet its current claims

14

D. What is Computron’s inventory turnover?

15

D. What are Computron’s days sales outstanding?

16

D. What are Computron’s fixed assets turnover, and total assets turnover ratios?

17

D. How does the firm’s utilization of assets stack up against that of the industry?

The company is utilizing its fixed assets at the industry average level, but its total assets turnover is below average

18

E. What are the firm’s debt and times‑interest‑earned, ratios?

19

E. What is the firm’s fixed charge coverage ratio? How does Computron compare to the industry with respect to financial leverage? What conclusions can you draw from these ratios?

20

E. How does Computron compare to the industry with respect to financial leverage? What conclusions can you draw from these ratios?

Computron’s debt ratio is above the industry average, and the trend is upCreditors have supplied over one‑half the firm’s total financingComputron probably would find it difficult to borrow additional funds at a reasonable cost without first raising more equity capital

21

E. What conclusions can you draw from these ratios?

Computron’s 2010 tie is below the industry average and falling, and this, like the debt ratio, indicates high and possibly excessive use of debtComputron uses substantially more fixed charge financing than the average firm in the industry, so it probably would have trouble obtaining additional debt or lease financing

22

F. Calculate and discuss the firm’s profitability ratios—that is, its profit margin, return on assets (ROA), and return on equity (ROE).

Computron’s profit margin is low and fallingThis indicates that its sales prices are relatively low, that its costs are relatively high, or both

23

F. Calculate and discuss the firm’s (ROA), and (ROE).

Computron’s ROA and ROE are substantially below the industry average, and fallingBecause they are poor, one would anticipate that the company’s common stock has not been doing very well

24

G. Calculate Computron's market value ratios‑‑that is, its price/earnings ratio and its market/book ratio. What do these ratios tell you about investors' opinions of the company?

25

G. What do these ratios tell you about investors' opinions of the company?

Computron’s P/E ratio would be well below the industry average, indicating that investors view Computron as being riskier and/or as having poorer growth prospects than the average firm in the industryIn 2010, Computron had a book value (of equity) per share of $685,988/100,000 = $6.86 and a stock price of $6.00, for an M/B ratio of $6.00/$6.86 = 0.9x - this is well below the 1.4x industry average

2010 2009 Industry

P/E 13.6x 9.7x 14.2x M/B 0.9x 1.3x 1.4x

26

H. Use the Dupont equation to provide a summary and overview of Computron’s financial condition. What are the firm’s major strengths and weaknesses?

Computron’s expense control as reflected in the profit margin is both poor and trending downIts total assets utilization is somewhat below average but holding steadyThese measures combine to produce an ROA that is very low and falling

27

I. Use the following simplified 2010 balance sheet to show, in general terms, how an improvement in one of the ratios—say, the DSO—would affect the stock price. For example, if the company could improve its collection procedures and thereby lower the DSO from 37.6 days to 27.6 days, how would that change “ripple through” the financial statements (shown in thousands below) and influence the stock price?

28

I. If A/R can be reduced to 27.6 days without affecting sales, then the balance sheet item A/R would be down $106,846 from the current level. That $106,846 could be used

1. to reduce debt, which would lower interest charges and thus increase profits

2. to buy back stock, which would lower shares outstanding and thus raise EPS

3. to invest in productive assets, which presumably would raise net income

29

J. Although financial statement analysis can provide useful information about a company’s operations and its financial condition, this type of analysis does have some potential problems and limitations, and it must be used with care and judgment. What are some problems and limitations?

1. Many large firms operate a number of different divisions in quite different industries, making it difficult to develop a meaningful set of industry averages for comparative purposes

2. Most firms want to be better than average, so merely attaining average performance is not necessarily goo

3. Inflation distorts firms’ balance sheets. and affects both depreciation charges and inventory costs, thus profits also are affected

30

J. Some of the problems and limitations of financial statement analysis

4. Seasonal factors can also distort ratio analysis5. Firms can employ “window dressing” techniques to make

their financial statements look better to credit analysts6. Different operating and accounting practices can distort

comparisons7. It is difficult to generalize about whether a particular ratio

is “good” or “bad” 8. A firm might have some ratios that look “good” and others

that look “bad,” making it difficult to tell whether the company is, on balance, in a strong or a weak position